Arbitration is a financial strategy that consists in taking advantage of the price difference between different markets on the same financial asset to obtain an economic benefit, usually without risk.
To perform arbitration, complementary operations (buy and sell) are carried out at the same time and wait for prices to adjust. The arbitration takes advantage of this divergence and obtains a risk-free gain. In other words, the arbitrajista is positioned short (sells) in the market with higher price and long (purchase) in the market with lower price. The benefit would come from the difference between both markets.
Arbitration is possible due to inefficiencies in the markets. When there is no possibility of doing so, it is said that the condition of non-arbitration is met. The more efficient a market is, the harder it will be to realize it.
Arbitration is considered risk free. However, if the difference is given by an inefficiency such as liquidity, it is possible that this liquidity does not allow us to take advantage of the price difference or that to take advantage of it we are assuming risk of price variation and therefore we are not actually performing arbitration.
In which markets can arbitration be done?
The different markets in which this strategy can be carried out are:
- Markets located in different places:For example arbitration between Frankfurt and Madrid or Chicago.
- Different types of market:For example, derivatives market and cash markets.
The operations of aribtraje tend to regulate the markets, since when selling in the market with greater price they generate an increase of the offer that causes the price to fall and when buying in the market of lower price they generate an increase of the demand that the price increase ( law of supply and demand ).
This rise and fall in price continues until the moment when it is no longer profitable to do this type of operations. That is, when the price of both markets is matched and therefore in balance.
Types of arbitration
We can distinguish several types of arbitration:
- Two-point arbitration:This is the difference between the prices of two markets directly.
- Three-point arbitration or triangular arbitration:In this case it is necessary to use three markets. The difference between two markets is imperceptible, but taking it to a third market becomes higher. For example, the difference between three currency pairs, changing EUR / USD, then USD / GBP and then EUR / GBP. It is a very difficult arbitration to observe and it is usually necessary to use computer tools to arbitrate it.
It should be noted that arbitration of three or more points can be carried out. Now, given its complexity, we will ignore it in this explanation. The objective is to explain the concept in a simple way, not to delve into its difficulties.
Examples of financial arbitration
For example, suppose that Banco Santander’s share is 6 euros and Santander’s financial future is 7 euros. We would buy Santander’s share in the spot market and at the same time sell the price of the future. After a while, when both have been adjusted, we will win the difference.
Another example, if the price of the euro / dollar in the Madrid market is 1.1 dollars per euro, but in New York is 1.05 dollars per euro.
Assuming that we can exchange in Madrid and New York at the same time the operation would be as follows:
- I buy dollars in Madrid: Changing for example 1,000 euros to dollars, as the change is € 1 = $ 1.1 receipt 1100 dollars.
- I sell those dollars in New York: I change the 1,100 dollars to euros. As the change here is € 1 = $ 1.05 they give me 1047.62 euros.
- I have won 47.62 euros without any risk. That is, we have made arbitration. So we would have had a profit of 0.05 cents for each risk-free euro (not counting commissions and others). With that strategy we are regulating the market and causing the price in Madrid of the dollar to rise and in New York to fall, adjusting so that there is no possibility of arbitration.